This paper was presented at the “The University's Contribution to Minnesota's Economic, Social and Cultural Vitality” conference, University of Minnesota, August 23, 2001.

The views expressed herein are those of the authors and not
necessarily those of the Federal Reserve Bank of Minneapolis or
the Federal Reserve System. We thank Mel Burstein, Mike Meyers,
Vernon Ruttan and Jim Simler for helpful discussions on this topic.

What role should the University of Minnesota play to ensure that the
state's economy does not falter and that the state maintains its economic
vitality? This was one of the key questions that motivated the university's
economic summit on the future of the state's economy in September 2000,
a forerunner to this year's conference.

Many of the conference attendees were concerned the state's economy
was beginning to falter. Some argued that Minnesota's economy was
already falling behind the rest of the nation in developing high-tech
companies. They noted the increasing number of corporate headquarters
that had left Minnesota in recent years. And they pointed to a precipitous
decline in venture capital funding going to Minnesota companies.
Others, however, were not convinced that prospects were as bad as
asserted, questioning the accuracy and relevancy of the data presented.
A recent study by the University of Minnesota's Humphrey Institute
of Public Affairs suggests that fears of falling behind have indeed
been exaggerated. It showed that Minneapolis-St. Paul ranks ninth
in the nation among U.S. cities in high-tech employment. (Markusen
et al., 2001)

Nevertheless, most agreed the university should take a more direct
and active role in promoting economic development and productivity
in the state. They argued for an explicit partnership between the
university and the local business community, with the objective
of turning out more commercially oriented research, research that
would result in more marketable products, more new businesses and
more high-paying jobs. While this line of reasoning at first appears
measured and persuasive, a closer examination raises doubts about
the net benefits from such a partnership. Indeed, we think the recommendations
that follow from this point of view can compromise the long-run
vitality of the state's economy.

That vitality depends on a university that produces basic research
and well-educated students. Because these products are types of
public goods, unfettered markets will fail to produce enough of
them. Public universities are designed to correct this market failure
by providing more education and basic research than the market would
yield on its own; these are the fundamental roles of a university
and the argument for government support.

In general, evidence suggests that the spillovers to local economies
from these public goods are substantial. And in particular, the
evidence on the University of Minnesota's impact on this state's
economy is impressive. Encouraging the university to do commercially
oriented research, therefore, can be costly in terms of the resources
that are diverted from its fundamental mission.

Moreover, not only are the costs high, but the benefits of having
the university pursue commercially oriented research are likely
to be small, if not illusory. Government attempts to promote commercially
oriented research, either directly or through universities, have
yielded mixed results. And a comprehensive look at these efforts
reveals a disturbing outcome: Government-sponsored research appears
to simply substitute for privately sponsored research. In other
words, the government's attempt to increase commercially oriented
researcheven if it is commercially successfulmay fail
because it drives out research that would have otherwise come from
the private sector.

A call for the university to provide
more commercially oriented research

Many of Minnesota's business leaders have concluded that the road
to economic prosperity is through a university that is tightly involved
with the private sector, particularly through conducting commercially
oriented research, licensing patents and providing assistance to
new technology-based companies. They contend that transferring university
resources directly to businesses creates a more vibrant economy
with more technology-based companies and high-paying jobs.

Proponents of direct involvement argue that the University of Minnesota
can do a better job promoting economic development in the state.
In spring of 2000, the Star Tribune published a commentary
titled "Smug too long, state starts to fall behind." The authors
argued that other states and cities are spending more on their universities
to bolster university-spawned technology and attract new companies
and talented workers. Meanwhile, Minnesotans have become too complacent.
(Berg and Hage, 2000)

At least partly in response to the concerns that Minnesota's economy
is falling behind, more than 1,200 business, government and academic
leaders convened for the University of Minnesota's economic summit
in September 2000. A working group of these leaders continued the
discussion that began at the summit. They concluded that the university
needs to take a stronger role in promoting the state's economic
well being and made the following recommendations (Working Group
Report, 2000):

Establish a mechanism by which investment in higher education
can better align with current and future business needs, and within
which progress can be monitored.

Participate in a public-private coalition to identify and support
key research areas critical to Minnesota businesses.

A call the university should not answer

The arguments for a more commercially oriented university appear
persuasive. How can we argue against the University of Minnesota
doing a better job commercializing new technology? Nevertheless,
we do. We think this road to success is not only bumpy, but also
headed in the wrong direction. The flaw in the argument begins with
a misunderstanding of the fundamental role of a university. And
this misunderstanding in turn stems from confusion about the public-goods
aspect of research and education.

A public good is distinguished from a private good by a special
feature known as the nonrival property: One person's consumption
of that good does not subtract from another person's. By this definition
it should be clear that an apple is not a public good; nor is an
automobile, or a cigarette, or a seat at a baseball game or a stay
at a hotel. In each example, consumption by one person precludes
consumption by others. Now consider the consumption of a lighthouse,
an often-cited example of a public good. The beam of light that
is seen (consumed) by one ship on a foggy night does not use up
the light; other ships still have the same beam of light to consume.
Similarly, consider research (both basic and commercially oriented).
Once produced, the research can be consumed without diminishing
its availability. Other examples of public goods include national
defense, clean air, a constitution or a legal system, and TV broadcasts.
These goods all satisfy the condition that any one person can consume
the good without subtracting from what others can consume.

Besides pure public goods and pure private goods there are private
goods that have some degree of "publicness." For example, the health
care provided to an individual is a private good because other individuals
cannot consume it; nevertheless, health care can have spillover
effects that benefit all individuals. Having one person inoculated
for some communicable disease makes for a healthier environment,
and a healthier environment is a good that any person can consume
without subtracting from the consumption of any other person. Similarly,
an educational service consumed by one individual precludes consumption
by others. However, the education of even one individual increases
the literacy of a community, which enhances the functioning of a
democracy and benefits all individuals.

Economists have found that while the production of private goods
is best left to market forces, the production of public goods may
not be. In general, the market fails to produce enough of these
goods because, once produced, people cannot be easily excluded from
consuming them. As a consequence, private producers of public goods
face a difficult pricing problem: Charging people for what they
consume is virtually impossible. For example, how much benefit does
one attain by consuming a healthy environment, or the national defense
system or a lighthouse beam? A private firm producing a public good
might try to survey the citizens of its community to uncover how
much they gain from consuming a public good and charge accordingly.
But such a survey is fraught with problems. Knowing they will be
charged based on how much they say they benefit from the public
good, and knowing they will get to consume as much as they want
regardless of their true preferences, people will tend to understate
their consumption. It follows that left to the market, too few public
goods, if any, will be produced. Consequently, we turn to the government
(the entity that has the power to tax all consumers) to decide which
public goods should be produced and in what quantity. With respect
to research, government must decide what type and how much should
be publicly funded.

Basic vs. commercially oriented research

We have argued that research is a public good and that unfettered
markets may not produce enough of it. However, we think it is important
to distinguish between research that the public cannot (or should
not) be excluded from consuming and research that it can be excluded
from consuming. The former we define as basic research; it has the
property that once produced it is virtually impossible to prevent
someone from consuming. The latter we define as commercially oriented
research; it has the property that, even though it is a public good,
it is relatively inexpensive to prevent someone from consuming.1/

Basic research is often research that aims to understand phenomena
at a relatively fundamental level and typically has no obvious practical
or marketable benefits. Basic research is a classic example of a
public good and a market failure, because it is virtually impossible
to capture the resulting benefits. When a mathematician publishes
a theorem, for example, she cannot prevent others from seeing and
building on her results. Of course, she could choose not to publish
her results, but then it is arguable whether she has produced any
research. The problem here is that it is virtually impossible for
the mathematician to directly capture the benefits of her work.
More generally, our definition of basic research is that its benefits
cannot be captured; hence, there is a market failure.

What about commercially oriented research? Clearly, not all research
is difficult to exclude others from using. Those who spend their
lives trying to build a new mousetrap, if successful, can legally
protect their new product and capture the benefits of the research
through a government patent. Patents are a relatively inexpensive
way to exclude people from consuming the benefits of research that
has a commercial application. They allow those who invested in commercially
oriented research to capture the benefits.

While we distinguish between basic and commercially oriented research
by how readily their benefits can be captured, we should also note
that there is a symbiotic relationship between the two. (See Ruttan,
2001, pp. 534-538, for a discussion of how complex this relationship
has become.) On the one hand, basic research is the foundation for
commercially oriented research. The fundamental principles of mathematics
and science underlay most of the commercially oriented research
that results in everyday products. Without this foundation, new
and improved products would be fewer and less frequent. Indeed,
a recent study by the National Science Foundation ("Industry Trends
in Research Support and Links to Public Research." National Science
Board, 1998) found that public investment in basic research often
serves as a precursor to private sector investment in many areas
of commercially oriented research and development. The study specifically
noted that US patents granted to US inventors were increasingly
citing publicly funded basic research from academic institutions.

On the other hand, much has been learned about the fundamentals
of science by doing commercially oriented research. Discoveries
found in commercially oriented research can comment on theories
developed in basic research. While both basic and commercially oriented
research are complementary, the question is to which type of research
the university should allocate its resources?

A high economic return to a university education
and basic research

We can think of public universities, therefore, as agents of the
government that provide two important public goods that unfettered
markets would not provide enough of: education and basic research.
While we cannot say whether universities are providing the right
amount of these goods, we do have compelling evidence that these
goods contribute to the economic well being of the local community.

The most direct contribution a university makes to its local economy
is by improving the quality of the local workforce through adding
more educated workers. Consider the results of a 1998 survey of
1996 graduates from the Twin Cities campus of the University of
Minnesota.2/ The
survey found that over 80 percent of resident students who earned
a baccalaureate degree were living and working in Minnesota. It
also found that over 50 percent of the nonresident students who
earned a baccalaureate degree were living and working in Minnesota.
(These percentages are somewhat lower for graduate and professional
degrees but they are still high.)

Furthermore, the economic value of a college degree is substantial
and has been increasing dramatically over the last 15 years. (See
Chart 1.) Prior to 1983 the wages of a worker with an undergraduate
degree exceeded a worker with a high school degree by roughly 40
percent. Today that difference is close to 60 percent. The wage
premium for an advanced degree has grown even more. Prior to 1985,
the wages of a worker with a graduate degree exceeded those of a
worker with a high school degree by roughly 60 percent. Today that
difference is over 100 percent.

The overall economic impact of a university is the result of both
its contributions to a higher quality workforce and to basic research.
By its very nature, however, the economic impact of basic research
is often indirect and difficult to quantify. A study that was successful
in isolating some of the impact of basic research found that there
was a positive association between basic research and industry research
and that it was basic research that appeared to cause industry research.
(Jaffe, 1989) Another study showed that spillovers from university
research are more localized than knowledge gained from other firms
within the industry. (Adams, 2001)

We can, however, estimate the total impact that a university has
on a local economy by comparing cities that have research-oriented
universities to those that do not. We took a sample of large cities
(Metropolitan Statistical Areas with population between 1.5 million
and 3.0 million) and small cities (Metropolitan Statistical Areas
with population between 500,000 and 1.5 million) that had universities
with high levels of research expenditures and generally large student
bodies. Annual research expenditures at the universities in large
cities ranged between $300 million and $500 million and in small
cities between $150 million and $275 million. We compared each sample
to cities of relatively the same size without research-oriented
universities. In the year 2000, large cities that are home to research-oriented
universities generated roughly 20 percent more income-per-capita
than other large cities; for small cities, this difference was 10
percent. (See Chart 2.) While we admit this is a rough first look
at the data, the results suggest that an active research university
is associated with a stronger local economy than an economy without
a research university.

The University of Minnesota is no exception

What can we say about the impact of the University of Minnesota
on our economy? The available evidence suggests that the university
is no exception to the general finding. This is not to say that
one can easily identify all the economic spillovers emanating from
the university. Nevertheless, the data we have make a compelling
case that the university has been critical to the success of Minnesota's
economy.

Consider what the university produces.
It annually ranks among the top 15 public and private universities
in research and development expenditures; in 2001 expenditures reached
over $400 million. Last year it graduated 4,900 students from its
four-year program and 4,100 students from its graduate and professional
programs, which include Business, Law, Medicine, Dentistry, Economics,
Political Science, Agriculture, Engineering, Computer Science and
many others. And as we noted, a high percentage of university students
live and work in Minnesota for at least two years after their graduation.

Over the years, we have seen some of the more successful spillovers
to the local economy. Many argue that Minnesota's medical technology
industry, which employed 20,400 workers in 2000, would not exist
without the people and the basic research coming out of the university.
In fact, from 1990 to 2000 the number of medical technology employees
grew 67 percent in Minnesota, while increasing only 17 percent nationally.
Other industries have benefited from university spillovers from
research in computer science, engineering and agriculture, to name
but a few.

Besides the anecdotal evidence that suggests the university has
been a key element in our state's economic success, the broader
macro data are impressive. Because of the university and the other
higher-education schools in our state, Minnesota has one of the
most educated workforces in the country. In terms of per capita
income and low unemployment, our state ranks among the top in the
country. (See Chart 3 on education ranking and Chart 4 on per capita
income and unemployment.)

A low return to university-sponsored, commercially oriented research

Economists often preach that there is no free lunch. What the government
spends on public goods, the public cannot spend on private goods.
What the government spends on education, the government cannot spend
on crime prevention. The time a student spends in school is the
time the student cannot spend working. If a university decides to
spend resources on consulting with businesses and doing commercially
oriented research, it will have less time to educate students and
produce basic research. Hence the cost of university-funded, commercially
oriented research is what is forgone in the way of education and
basic research. While it is difficult to document these costs precisely,
as measured only by their economic impact on the local community,
they appear to be substantial.

Not only do the costs appear high, but also estimates of the benefits
from university-funded commercially oriented research are low; they
may even be zero. As mentioned earlier, basic research is associated
with motivating private industry to do more of its own research.
It is possible that by having universities do more commercially
oriented research at the expense of basic research, the amount of
research private industry funds declines.

A more disturbing outcome is that overall research could decline
because any increase in commercially oriented research by universities
appears to be offset by a decrease in similar research conducted
by private industry; that is, in effect, universities fund the commercially
oriented research that private industry would have done on its own.
The irony here is that this substitution is more likely to occur
when the university-funded commercially oriented research is financially
successful. That is because research projects with the most potential
for financial success are those that the private sector would likely
have pursued if the university had not.

The federal government has tried in numerous ways to directly increase
the amount of commercially oriented research. One such program,
established by Congress in 1983, is known as the Small Business
Innovation Research Program (SBIR). Today over $1 billion of federal
grants are allocated by the SBIR. Under this program, small businesses
apply for research grants to fund proposals that the SBIR program
managers judge to have a high degree of commercial success.

While these dollars are clearly spent on commercially oriented
research, it is not clear if there is an increase in total research
expenditures. To try to determine the net impact of SBIR grants,
Scott Wallsten compared firms that received grants to firms that
did not. After devising a test that would take account of an important
feedback effect, he found that there was a dollar-for-dollar substitution.
(Wallsten, 2000) His results strongly suggest that firms that received
the research grants would have done the research without the grant
and that the government financing did not induce any more research
than it replaced.

Proponents of the university taking a more direct role in promoting
local economic activity, whether by funding more commercially oriented
research or by making its professors more available for consulting,
should be concerned by these results. They suggest that the net
benefits may not just be small, but are likely to be negative. And
ironically the more successful the university might be in turning
out patents and financially successful products, the more likely
the returns are negative. The returns are positive (and we estimate
to be quite large) only when the university is educating the local
workforce and doing basic research, research that private industry
would not do on its own.

Conclusion

The university can best promote the economic vitality of the state
of Minnesota by focusing on producing basic research and educated
students. Consequently, we think it would be a mistake to transfer
university resources to commercially oriented research. We do not
mean to suggest that the university cut its links with the private
sector and rest in an ivory tower. Rather, this paper suggests that
policymakers carefully weigh the costs and benefits of policies
that give the university a more direct role in promoting the state's
economy. Some policies require few resources relative to benefits,
such as providing channels for communication between university
researchers and the private sector. Even some incubator programs
that transfer university expertise to start-up companies may not
require substantial resources. When the university sets out to conduct
commercially oriented research, however, the costs are high and
the public benefits are suspect.

The road to a strong Minnesota economy to keep the university producing
what the private sector will not produce enough ofeducation
and basic research. To that end, we should judge the university
not by the number of patents it produces, but by the quality of
the scholarly journal articles its faculty publishes and the quality
of the students it graduates.

Endnotes

1/ Most of the literature on
this discussion distinguishes between basic and applied research.
For example, applied research facilitates practical problem-solving
in such fields as health, agriculture and civil industrial technology,
whereas basic research is more distant from immediate, practical
concerns (Rosenberg and Nelson 1993). It also seems that basic research
becomes applied research at the point where fundamental theories
begin to be used to develop a new technology or application. However,
this point is sometimes difficult to pin down.

In this paper we don't distinguish between basic and applied research,
but use the economic concept of public goods to determine whether
research is basic or commercially oriented. Note that the public
cannot (or should not) be excluded from consuming much of what scientists
consider as applied research, and therefore for this paper we consider
such research as basic. Policymakers can use our definitions of
basic and commercially oriented research to test whether particular
research projects are appropriate for the university or are better
left to the private sector.

2/ Office of Institutional Research
and Reporting, University of Minnesota.

Bibliography

Adams, James D. 2001. Comparative Localization of Academic and
Industrial Spillovers. Working paper, National Bureau of Economic
Research.